Stocks — Part XIV: Deflation, the ugly escort of Depressions.

In Part XII: Bonds, reader Chronicrants commented: “I’d love to see more on deflation. I’ve always been confused about it and about it’s consequences. It seems like it would be a good thing, and yet….” Great point, and what better topic, I thought, for unlucky number 13 in this series!

When deflation has come up in my previous posts it has been the ugly escort bringing Depressions to the Ball. Indeed here in the USA we have had four depressions since our founding in 1776: 1818-21, 1837-43, 1873-96 (the duration record holder) and the one we think of most often: The world-wide depression of 1930-33. In each case deflation was there, walking side-by-side holding depression’s hand.

So what the heck is deflation anyway? Simply put, it is the lowering of prices and the increasing of the value of money.

Hmmm…. As Chronicrants says, “It seems like it would be a good thing…” In many cases, it is. Let’s take a closer look.

Good Deflation.

One of the dynamic benefits of our economic system is the steady lowering of prices thru technological innovation and increased productivity. Perhaps the clearest example of this in recent decades is the rapid fall in prices and improvement of products in the electronic/tech world. The laptop or TV that was $2000 a few years back can be had now for $500. People never tire of pointing out that we carry more computing power in our phones than that on the Apollo moon missions.

As a percent of average earnings, the cost of food, housing and transport are all lower today than 50 years ago. Yet thru innovation and productivity gains, the companies that provide these things are doing better as well. Our money buys more of all these things and is thereby worth more than it was. This is deflation, and it is a good thing.

Ugly Deflation.

Deflation turns ugly when prices drop for reasons other than increasing innovation and productivity. This occurs during economic downturns. At first, this too can be a good thing, but the danger is slipping into a Deflationary Spiral. It looks something like this:

Unemployment rises — Demand for goods slows — Prices come down — Profits drop — Companies cut production — Unemployment rises faster — Demand for goods slows further — Prices fall — Profits drop — Companies cut production — and on. A few cycles of this and companies start folding and bread lines start growing. The cycle can start with any of these points along the line. It becomes a vicious circle that’s very tough to break.

The collapse of our housing bubble a few years back brought us to the edge of this abyss. The antidote is a nice healthy dose of inflation and that’s exactly what the Federal Reserve has been trying to reignite. It does this by lowering interest rates (now effectively zero) and pumping cash into the system. The idea is this will break the cycle and get companies ramping up and people spending again. It is an attempt to reverse the psychology.

The Psychology of Deflation.

Franklin Delano Roosevelt, the 32nd President of the United States (1933–1945), famously said, “The only thing we have to fear, is fear itself.” He was talking about the psychology that threatened to mire the country in its deflationary depression. Our housing crisis gives us an excellent tour of this in action.

Let’s suppose you were in the market to buy a house in 2005. Prices had been rising for years and the pace was accelerating. Every where you turned those who had bought were bragging about their gains. If you waited, a year from now you might be paying 10-20-30% or more for that same house. That not only raises your cost, it represents lost profitin your mind. You are filled with an urgency to ink a deal.

Of course, you are not alone in this thinking. Every time a house goes up for sale, scores of other people, driven by the same psychology, are competing with you for the privilege of buying it. Meanwhile sellers, also realizing that their house is increasingly more valuable, become more reluctant and scarcer. Up the prices go. Endlessly, or so it seemed.

What we had was an Inflationary Spiral. Just like with tulip bulbs in 1637, this bubble expanded till it burst. Then, on a dime, the psychology reversed.

At a certain point, people just couldn’t afford to buy houses at the price levels they’d reached. In fact, in this case with all the easy money that had been lent, many new owners couldn’t afford to own them in the first place. Suddenly, houses went up for sale and no buyers showed up. Prices softened. Owners started to see their values drop. They became more willing to sell, hoping to get out before prices dropped further. Fewer houses sold, even as more came on the market. Supply quickly outpaced demand. Prices dropped again.

Potential buyers, of course, also saw this happening.

It didn’t take long to realize that now waiting to buy paid off. The house you looked at today would still be for sale tomorrow and for less. Fewer people were able to buy and those that were, effectively got paid to wait. If you’ve been wondering why real estate brokers are so eager to declare home prices are rising again, it is this. Until buyers start to believe prices will be higher next year they’ll hesitate to buy now. Until then, housing is locked in this Deflationary Spiral.

The danger is, of course, that housing is a huge part of the economy. When housing sales slow it spills into the sales of lumber, appliances, furniture, windows, HVAC, flooring, garden equipment and a raft of other stuff, along with the jobs related to them. As those drop, other segments of the economy dependent on them and the folks that work for them get pulled down. If enough get caught in their own whirlpools, the entire economy enters the deflationary spiral. Next thing you know….

…Mr. Deflation is introducing you to Ms. Depression.

Deflation winners and losers.

As we’ve already seen, we all win thru the deflation of prices thru technological innovation and increased productivity. And it’s not hard to see the losers in a deflationary spiral: Companies fold, people get thrown out of work, investments collapse. But even these ugly deflations have winners.

Remember, deflation is the lowering of prices and the increasing of the value of money. Deflationary spirals simply accelerate this process. You win if:

You hold bonds. As you know from Part XII: Bonds, when you buy bonds you are lending your money. Deflation means that your money buys more when you get paid back at a later date. Providing, of course, the bond issuer survives the depression and has the money to pay. Default risk.

You are on a guaranteed fixed income. Those on Social Security and fixed pensions would benefit as their income buys more goods and services. Interestingly, Social Security has provisions to raise benefits in response to inflation, but none to lower them in times of deflation. Same is true of most pensions.

Now before you go out and sell everything and stuff the money in your mattress, it is worth noting the Federal Reserve is working overtime to reignite inflation. There is an old saying on Wall Street: “Don’t fight the Fed.” It is good advice.

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Comments

Yup, my grandma STILL hoards cash! It also looks like Australia will be at the very least slowly deflating over next year in regards to house prices. You’re not allowed to just walk away from your debts here though, so I don’t think we’ll have a big crash like you guys did… more likely a slow, drawn out deflation over many years like the Japanese have had recently. Hopefully it doesn’t end up with giant bread lines though!

Scary stuff. The recent economic debacle certainly makes you appreciate why depression era people horded cash – why they are still hording cash. An event like that has a lasting effect – a lifetime for many people.

On another note . . . I like the pace you are setting with posts. Keep up the good work! I’m looking forward to your post on target date funds as I am looking to roll some IRA’s over in the near future.

Hey Jim,
I was helping out a friend with investing/saving and such and I sent them to your website as I think it is the best beginner explanation of investing I have ever read. That is after reading over 50 books on investing and economics and about a million blog posts (maybe a few less than that:)). It turns out the best answers are very easy to find. In fact, I would bet a large sum that no matter how much I study and learn about finance and economics, I will not beat your methods. So, I have kind of stopped trying and started to learn about other things. Thanks for giving me more free time 🙂

While helping out my friend I thought it would be great if there was an ebook or book form of all of your posts that one could read straight through. It would be short and as a consequence not daunting to inexperienced folks. I think it would be very helpful to people my age (20s). Do you have plans to make something like this?

Also, I have been getting the buy a house itch lately. Too much Mr Money Mustache I guess. On one hand it feels like a huge commitment and seems like it will cut down on my freedom. But, the leverage and prices are so very attractive and I am worried I will miss that boat and regret it later. Can you tell me something on the contrary?

That is: Can you think of any reasons why the low rates and prices may not be that great of a reason to buy a house and I will be fine if I wait? The housing industry does a very good job of getting people into houses, I guess:)

…that is high praise indeed, especially as that is precisely my objective. Hope you pass the blog along with your recommendation.

Regarding an eBook, I am exploring the idea of doing exactly that. Wouldn’t be all the posts, but rather just those focused on The Simple Path to Wealth and demystifying investing and the stock market. I hope to turn my attention to it early next year. While most of the basic material is written, it is still a formidable project organizing it and rewriting so it flows as a book. In fact, I just had a conversation today with a fellow who has published several.

As to buying a house, it is a very personal decision entailing many confusing factors only you can sort thru.

Reading your comment I get the feeling you don’t especially want to own a house. It is more that you think today’s market and interest rates offer a unique opportunity you don’t want to miss. If I’m right about that, run the numbers. Unless they say owning is overwhelmingly cheaper than renting, relax and enjoy your freedom.

For those who really want a house, now is probably a better time to be a buyer than most.

But for those who are just thinking they ‘should’ buy a house, it is the tail wagging the dog. No point in buying anything, houses included, you don’t really want/need just because it is a ‘good deal.’ That’s the psychological ploy marketers use all the time: “There will never be a better price/opportunity to buy than now!!”

The money you keep invested will do just fine not tied up in a house. Especially if renting is less expensive and you have the discipline to save the difference.

Hope that helps! Oh, and as it happens my life is going splendidly. Thanks for asking. Hope yours is too!